Last year was the most challenging one for bonds for four decades. Indeed, over the past 40 years, bonds and stocks slumped together twice, but 2022 was a standout as bonds declined more than 10%, compared to equities which fell eight percent. Investors as well as professional money managers are asking: will 2023 bring another year of bonds losing value?
“We don’t believe so. It won’t be another negative year,” says Dagmara Fijalkowski, head of global fixed income and currencies at Toronto-based RBC Global Asset Management Inc. (RBC GAM). Fijalkowski is also the lead manager of the $22.3 billion 5-star silver-rated RBC Bond Fund F (also available in Series D), the largest bond fund in the country. “Bond yields are now higher than they have been since 2008. To our minds, bonds offer the most compelling potential since the great financial crisis, especially since inflation has been cooling down and economic activity is slowing. We believe that bonds should post returns somewhere in the mid-single digits over the next year.”
Fijalkowski and her team of 23 portfolio managers and analysts, rely on scenario analysis to determine where interest rates and credit spreads may be going. “It depends on the scenario. Conservative scenarios see 1-2% returns. But the base case for us is around 6-7% returns, before fees. There are more optimistic scenarios, although it depends on what happens with corporate credits—and how deep the economic slowdown is.”
Bond Yields Point to Positivity
Yields are a good predictor of future returns, says Fijalkowski, a 28-year industry veteran who holds a master’s degree in economics from Poland’s University of Lodz and an MBA from the Ivey School of Business at the University of Western Ontario. “Yields are three times as high as they were at the end of 2020, before the very negative times for bonds. At the end of 2020, investors earned positive returns on bonds, and they really loved bonds. There were lots of inflows at that time. We are in a 180-degree opposite scenario than we were then. Yields are much more attractive.”
In addition, Fijalkowski notes that since March 2021 the yield curve has been flattening. “This bearish flattening has led to an extreme inversion in the yield curve. But this stage of flattening is typically followed by bullish steeping. That may be triggered by the tightening cycle nearing an end. Bullish steepening is typically accompanied by positive returns for bonds, which are driven by carry [income] and capital gains.”
In the 12 months ended January 6, RBC Bond Fund F returned -9.23%, versus -8.70% for the Canadian Fixed Income category. On a longer-term basis, however, the fund outperformed and returned an annualized 0.78% and 2.03% over five and 10 years. In contrast, the Canadian Fixed Income category returned an annualized 0.31% and 1.28% respectively.
Market Assumes a Mild Recession
From a macroeconomic perspective, a weakening economy is beneficial for bonds since bond prices move up as yields fall in response to a slowing economy. “The vast majority of economic indicators imply that we are near the end of the economic cycle,” says Fijalkowski, "The market assumes right now that this cycle in North America will end with a short and shallow recession. There are other economies such as in Europe, which are going through more dire straits. So, the recession probability is much higher there.”
However, Fijalkowski notes there is one scenario that outlines a nasty surprise with a much sharper recession than many are contemplating. “For now, the job market is still fairly strong and it’s hard to call for an extended and painful recession. That’s why the market and central bankers are talking about a short and shallow variety of recession.”
The RBC GAM team looks at several scenarios and most of them call for lower government bond yields going forward. “The ones that call for higher yields are in the minority and are associated with a bearish steeping yield curve,” says Fijalkowski, adding that would happen if the U.S. Federal Reserve (Fed) paused the hiking cycle too early, “If they declared victory too early, they would lose the hard-earned credibility and the market would start pricing in a resumption of inflation through a bearish steepening of the yield curve.”
Although Fijalkowski believes this scenario has a low probability of happening, her team doesn’t completely dismiss it because there is no way of knowing for sure what the Fed is going to do. “On a positive note, the majority of scenarios lead to flat or lower yields from here. Forecasts get old very easily in these markets because we very recently went from 4.4% to 3.4% for 10-year U.S. treasury bonds. But our 12-month forecast calls for a 3.7% yield [for U.S. 10-year treasuries], and that’s quite conservative for bond yield moves. There are some other plausible scenarios that call for a steeper slowdown, with inflation coming down nicely, including services. This scenario could see 10-year U.S. treasuries fall to around 2%.”
Base Case Sees a Couple More Hikes
RBC GAM’s base case scenario is that the Fed funds rate peaks at around 5%, which implies one or two more rate hikes. But the most important factor, Fijalkowski argues, is that inflation numbers steadily fall to reach around 4% by mid-2023. “In that case, it would suggest that a lot of things that the Fed was hoping for are indeed happening. So, base effects take place, and commodity prices keep coming down. Importantly, services ex-housing also peaks and these prices also come down,” says Fijalkowski. “If CPI declines are on target to achieve something like 4%, then the Fed would believe that 5%-5.25% is enough. Then we could say that ‘the worst in bonds is behind us.’ That’s our base case.”
Conversely, the worst-case scenario involves a bearish steepening of the yield curve and would occur if inflation remains stubbornly high. “By mid-year, you are not going towards 4%, but let’s say inflation hits 6%. That would suggest to the Fed that they have to do more,” observes Fijalkowski. “It means that the peak in the Fed funds rate would have to be higher than 5%, or even higher than 6%. If that is the case, I would call it ‘losing the plot.’ They are forgetting their job is to maintain the value of money and to bring inflation down and they may be calling victory too early.”
Don’t Look for the Fed to Let Off
This scenario has a low probability because, Fijalkowski argues, the U.S. Federal Reserve has learned a lot of lessons from the high inflation 1970s. At the Jackson Hole meeting last August, Jerome Powell, the chairman, said, ‘We will keep at it until the job is done.’ “That’s no coincidence because ‘Keeping at it’ is the title of the autobiography of Paul Volcker [chairman of the Fed in the 1980s],” observes Fijalkowski. “Powell used that phrase very deliberately to indicate that the Fed’s credibility is at stake. So, the scenario that the Fed declares victory too early is a low probability.”
From a strategic perspective, the RBC GAM team is maintaining a balance between government and corporate bonds with 49% in the former and 47% in the latter. “We have been adding investment-grade corporate exposure, particularly Canadian bonds and it’s mostly in the front end of the yield curve. These are shorter maturities where yields are attractive and spreads have widened a lot, pricing in a lot of negative news and a potential recession, or at least a very meaningful slow-down.”
More Confident on Corporate Credit
In contrast, the benchmark FTSE Canada Universe Bond Index has only 26% in corporate bonds and the balance in government bonds. “Canadian corporate bonds have very rarely been priced so attractively. Less than 10% of the time, historically, corporate bonds have been priced cheaper than now based on spread terms. We think that a lot of bad news is priced already into the bonds. They reflect a significant slowdown. This is especially so at the front end of the yield curve.”
Fijalkowski notes that currently, the market is seeing high government bond yields and wide spreads over corporate bonds. “The yield would have to double in one year before you lost money on two-year government bonds. The front end of the curve is so high. When you combine the high government yields and wide corporate spreads, and the fact that we have an active credit team that evaluates corporate bonds so that the probability of default is extremely low, then that’s why we have high conviction and hold a significant overweight in short-term corporate bonds.” The spread at the short end is about 155 basis points over government bonds.
Big on Bank Bonds
The fund is highly diversified and has over 1,000 securities. The top 10 holdings are comprised of government bonds and account for about 17% of the portfolio. From a sector viewpoint, Canadian banks, such as Toronto-Dominion Bank (TD), are among the top corporate bond holdings. As for duration, the portfolio stands at 7.2 years, slightly below the benchmark duration of 7.4 years. Currently, the fund has a yield of about 4.5%, before fees.
Looking ahead, Fijalkowski says that the next few months will be critical because market participants will have a few more data points on declining inflation and falling wage expectations. “And we need to see, and confirm, the peak inflation measure in core services, excluding housing, because housing is a calculated number that comes down very slowly,” says Fijalkowski. “If these things materialize—lower inflation, lower wage expectations and a decline in services prices---then we can confirm our base case about peak Fed funds indeed being around 5%, and rates will be coming down. Of course, by the time we have certainty, yields will be significantly lower.”
